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Investing through volatility

CompareStructuredProducts.com - 09/08/2023

Volatility is a statistical measure of the tendency for the value of an asset’s price to move in either direction away from its average price over time.

If an asset has high volatility the price of the asset will be spread over a greater range of values, whilst low volatility suggests that the price deviates across a smaller range. A Targeted Absolute Return fund, demonstrated by the IA Targeted Absolute Return sector average shown in blue on the chart below has low volatility, whilst a Commodities fund, demonstrated by the IA Commodity/Natural Resources sector average shown in red, has high volatility. This is because there are greater swings in price from the returns over a given time period.

The price of a structured investment is in part determined by the implied volatility of the underlying asset. Unlike historic volatility, which measures the actual variation over a given timeframe in the past, implied volatility is a measure of the expected range of price movements in the near future. For the probability models used to price the Financial Derivative Instruments (FDIs) present within structured investments, the implied volatility looks at the 34% most likely price movements in either direction, giving a span of the 68% (one standard deviation) most likely potential price movements at a given point in time.

The sensitivity to implied volatility of the FDIs within a structured investment is known as Vega. Academic studies suggest that the Vega within a structured investment is typically less than that of the underlying asset, and their pricing therefore tends to be less volatile than that of the underlying index. This is distinct from the additional risk exposure taken through the adoption of counterparty credit risk, and interest rate risk which also contribute towards the pricing of the structured investment.

As well as affecting the pricing of a structured investment, volatility also affects the potential returns offered by structured investments. This can be demonstrated by comparing two structured products which, despite having the same shape (i.e. the same maturity reference level of the initial level in each case; the same frequency of early maturity observations and the same capital protection barrier) began at different times, when volatility in the FTSE 100 and index position was very different.

The first offered a 16.6% return for each year held, maturing on the first of the pre-defined observation dates that the FTSE 100 Index was above the initial index level (6,721.17).

The second has similar maturity parameters albeit with an initial index and maturity trigger level of 7,203.29 but offered a lower potential 10.75% return for each year held.

Whilst these two strategies had some differing factors, not least different counterparties the large variance in return offered can largely be attributed to the volatility of the underlying asset (the FTSE 100 Index) at the time they were structured. Volatility was much greater in December 2018, when the first was created, but had fallen considerably by the time the second was introduced in May 2019.

So, whilst structured investment terms can vary according to volatility in the underlying measure, over the medium to long term their pricing tends to be less volatile than the underlying index itself. This can be comforting when markets have been powering ahead and investors are worried that a downturn may be coming. They have the knowledge that their investments are likely to be less volatile than the market, and they are still accumulating potential gains whilst giving time for the market to recover. Not to mention their capital having a degree of contingent protection.

Conversely, they can be a good investment to use in bear markets, where the strike levels are low and volatility is high, leading to improved terms, and again the inbuilt protections can provide comfort to those nervous of investing in a falling market. Of course, when markets are neither relatively high or low, the predefined nature of the returns investors can expect gives them a unique advantage over many alternatives.

Past performance is not a guide to future results

Structured investments put capital-at-risk.